When are agreed damages clauses in contracts unenforceable penalty clauses rather than enforceable liquidated damages clauses?

When negotiating a contract the parties commonly think about what should happen in the event that the other party breaches a term of the contract. They may also wish to stipulate what should happen upon the occurrence of a certain event (which may not technically constitute a “breach” of the contract). The other party might be required to pay an amount of money or provide some other non-monetary benefit as a result under the contract. Often it is difficult at the time the contract is made for a party to anticipate or foresee exactly what the damage or loss will be in the future if specified event(s) occur. Nevertheless, many contracts do specify what should happen upon the occurrence of certain events.

Breach of contract: If the parties agree on what will happen in the event of a breach of the contract, then the clause will either be (1) enforceable because it is a liquidated damages clause or (2) unenforceable because the clause is deemed to be a penalty.

Primary contractual stipulations with secondary collateral stipulations: Where a technical breach of the contract does not trigger what will happen but rather it is some other contractual stipulation / event which triggers payment, the question is “whether the party is restricted by covenant from doing the particular act [by] … payment”.  This might occur for example through the imposition of a collateral contractual stipulation which imposes an additional detriment to the benefit of a party and acts as security for the performance of the primary obligation, or acts as a deterrent to non-performance of the primary obligation. Such a stipulation would be a penalty. Alternatively, the question is “whether according to the true construction of the contract, its meaning is, that the one party shall have the right to do the act, on payment of what is agreed upon as an equivalent[1]” it which case it would be enforceable.

Enforceable agreed damages or liquidated damages clauses

Generally, the law will enforce a clause which provides for the payment to a party of an amount (or benefit) which is a “genuine covenanted pre-estimate of damage[2]”.

Unenforceable penalty clauses

In summary, clauses which are in the nature of a punishment for breach of the contract or to deter non-performance of a contractual term can be characterised as penalties and therefore unenforceable.

Factors which indicate an unenforceable penalty clause include where[3]:

  1. The agreed sum is “extravagant and unconscionable in amount in comparison with the greatest loss that could conceivably be proved to have followed from the breach”. The sum needs to be out of all proportion to the damage that would normally be awarded by a Court in the absence of the clause (i.e. it is “in terrorem”). This is the most important test and merely because no pre-estimate was made at the time the contract is entered into does not determine that the clause a penalty[4]; or
  2. The breach consists only in not paying a sum of money, and the agreed damages are more than what should be paid as a result; or
  3. A single lump sum is made payable by way of compensation on the occurrence of one or more events, some of which may occasion serious damage but others insignificant damage.

General principles

It is important to keep in mind the following:

  1. The circumstances and the terms of the contract as at the time the contract was made are relevant, not the circumstances at the time of the breach of contract;
  2. The fact that it was difficult or impossible to precisely estimate the likely damage at the time the contract was made does not determine that it is a penalty clause[5];
  3. The substance and effect of the clause must be considered (not merely the way the clause has been described in the contract); and
  4. The burden of proving that the clause is a penalty and unenforceable is on the defendant (i.e. the breaching / paying party).

Special rules apply where payment is accelerated and damages for loss of bargain are payable (for example which often appear in hire purchase agreements).  These are treated differently and specific legal advice should be sought[6].

A party seeking to rely upon an agreed damages clause would be best advised to draft the clause with the above in mind and to keep a note of the basis for the calculation and estimate of the damages.

Contact our Sydney business lawyers for assistance in relation to the above.  Our commercial lawyers, business lawyers, and disputes lawyers provide expertise in corporate and commercial advisory services as well as litigation and dispute resolution.  Take a look also at a sample selection of our more basic fixed fee legal services.

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The information provided in this article is provided by way of general information only. It does not constitute legal advice, and should not be relied upon as such. Specific independent legal advice should be obtained before deciding to act, or not to act, upon the views expressed or information contained in this article.

Copyright of Heathfield Grosvenor 2017. All rights reserved.

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[1] See Andrews v Australia and New Zealand Banking Group Limited [2012] HCA 30 and Paciocco v Australia and New Zealand Banking Group Limited [2016] HCA 28 (27 July 2016)

[2] Clydebank Engineering and Shipbuilding Co. v. Don Jose Ramos Yzquierdo y Castaneda [1905] A C 6.

[3] See Amev-Udc Finance Ltd v Austin (1986) 162 CLR 170 and Dunlop Pneumatic Tyre Co Ltd v New Garage and Motor Co Ltd [1915] AC 79

[4] Paciocco v Australia and New Zealand Banking Group Limited [2016] HCA 28 (27 July 2016)

[5] This was the fourth “test” from Dunlop Pneumatic Tyre Co Ltd v New Garage and Motor Co Ltd [1915] AC 79

[6] See Melbourne Linh Son Buddhist Society Inc v Gippsreal Ltd (No 2) [2017] VSCA 198 (4 August 2017) for a recent application of the principles.

 

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